Managerial Economics Project-check

7/28/2019 Managerial Economics Project-check

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A study on ELASTICITY DEMAND AND SUPPLY

Submitted in partial fulfillment of the requirements for the award of

MASTER OF BUSINESS ADMINISTRATION IN

MANAGERIAL ECONOMICS

Submitted by

Sunil B

to

Affiliated to


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Production & Operation Management Page 2

ACKNOWLEDGEMENT

First and foremost, I thank the Almighty God,my parents,teachers and friends.

This project bears imprint of all those who have directly or indirectly

helped and extended their kind support in completing this project.

At the time of making this project I express my sincere gratitude to

all of them.

I express my profound gratitude to my project guide

Prof.LAKSHMI KANNAN, my College Dean Mr.NEHERUJI for their

constant guidance and encouragement and very kind support and

valuable guidance in completing my project.

At this moment I also thank almighty, my Parents and God for the

blessings showed upon me and also my Friends for their valuable

suggestions.

I express my sincere thanks to the concerned people for grantingpermission to conduct my project work in his esteemed concern andfor helping and providing various information and data.


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STUDENTS DECLARATION

I, Mr.Sunil B hereby declare that the Pr oject Work titled ELASTICITYOF DEMAND AND SUPPLY is the original work of mine andsubmitted to the South Asian University in partial fulfillment of requirements for the award of Master of Business Administration inMANAGERIAL ECONOMICS.

Date

Signature of student


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ELASTICITY OF DEMAND AND SUPPLY

A) DefinitionElasticity is the ratio of relative change of a dependent variable to

changes in independent variables.

Elasticity can be analyzed in terms of demand and supply.

Elasticity of supply refers to the measure of the extent to which

quantity supplied of a commodity responds to changes in price of the commodity, prices of certain other goods, or any other factor

influencing supply.

Elasticity of Demand

Elasticity of demand refers to the measure of the extent to which

quantity demanded of a commodity responds to changes in any one

of the influencing factors. That is, price of the commodity,

consumers income, prices of other related goods, advertising or

any other factors influencing demand

There are 3 types of elasticity of demand:

1) Price elasticity of demand

2) Income elasticity of demand


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3) Cross elasticity of demand.

1) Price Elasticity of DemandThis is defined as the measure of the degree of responsiveness

of quantity demanded to a change in the price of a commodity

(Ceteris Paribus) it is calculated using the following general

formula.

Price Elasticity of Demand =

PED = ED = Proportionate change in quantity demanded

Proportionate change in price

If a proportionate change in price causes a more than proportionate

change in quantity demanded, demand is said to be price elastic

e.g. 100% change in price resulting in a 150% change in quantity

demanded. The value of ED in this case will be greater than one

i.e. ED > 1

If a proportionate change in price causes a less than proportionate

change in quantity demanded, demand is said to be price inelastic


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e.g. 100% change in price resulting in a 50% change in quantity

demanded. The value of ED in this case will be less than one i.e.

ED < 1.

To illustrate price elastic and inelastic demand, consider the table

below showing the demand schedules for commodity X and Y.

Commodity X

Commodity Y

Shs. Per unit. Quantity

demanded per

week.

Shs. Per unit Quantity

demanded per

week.

10 100 10 100

5 250 5 120

For commodity X

ED= proportionate change in quantity demanded

Proportionate change in price.


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Proportionate change in quantity demanded = 150 * 100 =150%

100

Proportionate change in price = - 5 * 100 =-50%

10

ED= 150 = -3

-50

IEDI = 3

In absolute terms, a proportionate change in price causes a more than

proportionate change in quantity demanded of X

IEDI = 3 therefore IEDI > 1

Thus the demand for the commodity is said to be price elastic.

For commodity Y

ED = Proportionate change in quantity demanded


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Proportionate change in price

Proportionate change in Quantity demanded = 20 *100 = 100%

100

Proportionate change in price = -5 *100 =-50%

10

ED = 20 = -0.4

-50

IEDI= 0.4

In absolute terms, a proportionate change in price of commodity Y

causes a less than proportionate change quantity demanded of

the commodity,

i.e.IEDI


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If a proportionate change in price causes a proportionate change in

quantity demanded, demand is said to be unit price elastic.

Measurement of price elasticity of demand

Price elasticity of demand can be measured in two ways:

i) Point elasticity of demand

ii) Arc elasticity of demand

i) Point Elasticity of Demand

This is the measure of price elasticity of demand at a

particular price or a particular point on the demand curve. It

is valid for very small changes in price. For a straight-line

demand curve, point elasticity of demand can be found by

using the following formula

Point ED = Q/Q = Q * P

P/P P Q


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Where P is the price at the point and Q is the quantity at the

point of measurement.

"(Q/P)" is the derivative of the demand function withrespect to P. "Q" means 'Quantity' and "P" means 'Price'.

To illustrate this consider the diagram below:

To illustrate point price elasticity with a straight line demand

curve

Point ED = Q * P = Q * P = Q * P2 (at point B)

P Q P Q P Q2

For a non linear demand curve, Q will refer to the slope at

the point of


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P

tangency to the curve at the point of Measurement. This is

illustrated below

To illustrate point price elasticity with a non-linear demand

curve.

Point ED (at point A) = Q * P

P Q

= Q *P1

P Q1


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Q = 1

P Slope

Hence the slope is equal to P / Q

Where the slope refers to the slope of the tangent TT

Example 1

Demand curve: Q = 1,000 - 0.6P

a.) Given this demand curve determine the point price elasticity of

demand at P = 80 and P = 40 as follows.

i.) obtain the derivative of the demand function when it's expressed Q as

a function of P.

Q = -0.6

P

ii.) next apply the above equation to the sought ordered pairs: (40, 976),

(80, 952)

PED = Q * P

P Q

e = -0.6(40/976) = -0.02

e = -0.6(80/952) = -0.05


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Example 2

Consider the following DD schedule, compute the price

elasticity of demand and when price =6 when

Price = 4

Price per unit of X Quantity demanded per week.

8 0

7 5

6 10

5 15

4 20

3 25

2 30

1 35


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a. PED when P=6

Point ED= Q * P

P Q

At P= 6, Q=10, therefore, Point ED = Q * 6

P 10

Q =1

P Slope

Slope = -1 = -0.2

5

Point PED (at price 6)= Q * P = 1 * 6

P Q 0.2 10

Point ED= -3


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Point IEDI = 3

Thus demand is price elastic at P = 6

b. When P=4

Point ED = Q * P = Q * 4

P Q P 20

= Q = 1

P slope

Slope = - 0.2

Point PED = Q * P (at P=4)

P Q

=-1 * 4

0.2 20

Point ED =-4 = -1

4

Point IEDI= 1

Thus demand is unit price elastic at P= 4


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Example 3

Given the following demand function, determine the point

elasticicity of demand at the given prices.

Qd=10-2P 2

Find PED at P=1, P=2 and P=3

When P=1

Q=10-(2*1*1)

Q=8

Slope= P

Q

1 = Q =-4P= (-4*1)

Slope P

Point PED= 1 *P

Slope Q

=-4*(1)

8

= -0.5


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IPEDI= 0.5

Demand is price inelastic at P=1

When P=2

Q=10-(2*2*2)

Q=2

Slope= P

Q

1 = Q = -4P=(-4*2)=-8

Slope P

Point PED=1 * P

Slope Q

=-8* 2

2

=-8

IPEDI=8

Demand is price elastic at P=2


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When P=3,PED=4.5 and demand is price elastic.

(Students work this out)

2

Example 4

ii. P=10-Q 2

Find price elasticity of demand when Q=3

PED= Q * P=

P Q

Q = -1

P 2Q

P=10-(3*3)

P=1

Q *P =-1 * 1

P Q 2Q 3

= -1


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(6*3)

= -1

18

IPEDI= 1

18

Demand is price in elastic when Q = 3

When Q=1(students to work out this)

ii) Arc Elasticity of Demand

This refers to the measurement of price elasticity between

two points on a demand curve (between two prices). It is

calculated both for linear and non-linear demand curves

using the following formula:

Arc ED= Q *(P1+P2)/2

P (Q1+Q2)

= Q * p1+p2


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P q1+q2

In the formula above, P1 and Q1 represent the initial price

and quantity respectively.

Thus (P1 + P2)/2 is a measure of the average price between

the two points along the demand curve and (Q1 + Q2)/2 is

the average quantity in that range. Graphically, Arc elasticity

can be illustrated as follows:

To illustrate Arc elasticity of demand

For linear demand curves For non-linear demand

curves.

Arc ED (at point A and B)= Q * p1+p2


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P q1+q2 Arc ED(at.

Pt.Cand D)

Q * p3+p4

P q3+q4

Given the following data, calculate the price elasticity of demand

in the price range of 5-6 and 1-2. The data is as follows

Price\unit Quantity demanded\week

8 0

7 5

6 10

5 15

4 20

3 25

2 30

1 35

For the price range of 5-6

Arc elasticity of demand = Q * p1+p2


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P q1+q2

p1=5 q1=15

p2=6 q2=20

Q=-5

P=1

Arc ED= -5 * (5+6)

1 (15+10)

Arc PED= -2.2

Arc IPEDI= 2.2

Thus demand is price elastic between p=5 and p=6

For the price range, 1-2, demand is price inelastic and Arc ED is 0.23

(Students should work this out)

Qd=10-P 2

Find PED on the price range P=1 and P=2

When P=1,Q=8

When P=2, Q=6

Arc ED= Q * p1+p2


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P Q1+Q2

Q=-3

P=1

= -3 *(1+2)

1 (6+9)

= -0.6

Arc IEdI=0.6Thus demand is price inelastic between P=1 and P=2

Example ( check)

If Demand changed from 8 units to 12 units, the midpoint percent

change would be (12-8)/((12+8)/2))=40%. Normal percentage change

would equal (12-8)/8= 50%. The midpoint formula has the benefit that a

movement from A to B is the exact negative of a movement from B to

A. In our example, the midpoint percentage would be -40%, whereas our

normal percentage change would be -33.3%.

In the above example, assume the change from 8 to 12 units demanded

was caused by a change in price from $3 to $1. The midpoint percentage

change of price would be -100%. Therefore, the price elasticity of

demand would be: (40%/-100%) or -40%. Often when speaking of price


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elasticities, it is common to write it as the negative or absolute value of

the elasticity, such that price elasticity becomes a positive number.

Price Elasticity of Demand and the Demand Curve

On any demand curve PED would be different at different prices.

To illustrate this consider the diagram below:

To illustrate the relationship between PED and the demand curve

Check bk

When price changes from 50-40 quantity demanded increases from 4-6

units, in this case PED = 2.5 and demand is price elastic.


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When price changes from 40-30, quantity demanded increases

from 6-8 units, in this case PED = 1.33 and demand is price elastic.

When price changes from 30-20, quantity demanded increases

from 8-10 units, in this case PED = 0.75 and demand is price

inelastic.

Price elasticity of demand along a straight line demand curve is

thus not the same at all prices. There are 3 exceptional cases,where price elasticity of demand is the same at all prices i.e.

throughout the demand curve. These are illustrated below:

To illustrate the exceptional cases


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Perfectly price elastic perfectly price inelastic Unit

price elastic

In the case of perfectly price inelastic demand curve, quantity demandeddoes not change with changes in price i.e. quantity demanded is the

same at all price levels. In this case, demand is described as being

perfectly price inelastic. An example of a commodity with this kind of

demand is insulin, which is consumed, in fixed amounts. Insulin is

described as a being an absolute necessity.

In the case of perfectly price elastic demand curve, price is the same at

all levels of demand. In this case demand is described as being perfectly

price elastic. An example of this is the demand curve facing a perfectly

competitive market i.e. one with many buyers and sellers for a

commodity and the sellers are producing a homogenous commodity.

In the case of unit price elastic demand curve, quantity demanded

changes at the same proportion as the change in price at all price levels.

Demand in this case is described as being unit price elastic.

Determinants of Price Elasticity of Demand


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1. Availability of Substitutes: The greater the number of

substitutes for a commodity over a relevant price range, the

greater will be its elasticity of demand. This is because

consumers can respond to an increase in price of the

commodity by switching expenditure away from it and

buying instead the substitute. If perfect substitute of a

commodity are available demand is likely to be highly

elastic. Conversely if no substitutes are available demand

would be price inelastic.

For example, if the price of a cup of coffee went up by

$0.25, consumers could replace their morning caffeine with a

cup of tea. This means that coffee is an elastic good because

a raise in price will cause a large decrease in demand as

consumers start buying more tea instead of coffee.

A contrasting inelastic good would be water which is

arguably insubsitutable so a local community faced with

rising water costs will be left with little choice but to pay the

increased costs forming an price inelastic good

2. Proportion of Income Spent on a Commodity: The greater

the proportion of income which the price of a commodity

represents the greater would be its price elasticity of demand


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e.g. a 50% increase in a price of a match box will not have

the same effect on quantity demanded as a 50% increase in

the price of cars.

3. Time: Following a change in price, of demand would be

greater in the long run than in the short run e.g. an increase in

the price of meat will not change peoples eating habits

overnight only, if this prices remain high people are

eventually going to look for substitutes.

For example, in the short run, the price elasticity of demand

for fuel may be low because people have few options. But

over a longer period, the price elasticity of demand for fuel

may be much greater than in the short run as people replace

their high fuel consuming vehicles with fuel efficient,compact vehicles, switch to car pools and to public

transportation, and take other steps to reduce fuel

consumption.

4. Durability: The greater the durability of a product the greater its elasticity of demand and vice versa e.g. if the price of salt

increases it is not possible to use the salt twice. However, if


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the price of furniture rises it can be made to last a little

longer.

5. Width of the Market: The wider the definition of a market for

a commodity the more inelastic its demand is e.g. the demand

for a particular brand of cigarette will tend to be elastic

because of other brands which are close substitutes, while the

total demand for cigarettes will be price inelastic.

6. Nature of the Commodity: In general, the demand for

luxuries will tend to be price elastic while that of necessities

price inelastic. However, if no obvious substitutes exist for

luxurious commodities its demand will be price inelastic.

Also if, there are substitutes for a necessity, its demand will

be price elastic.

7. LLeevveell oof f PPr r iiccee: Since price elasticity is different at different

prices then the initial price is an important determinant of

elasticity of demand.


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8. Number of Uses: The greater the number of uses to which a

commodity can be put, the greater its elasticity of demand e.g.

electricity has many uses i.e. heating, lighting, cooking etc. A

rise in price of electricity will therefore cause people not only to

save on usage but also to find substitutes.

Relationship between Price Elasticity of Demand and Revenue

This relationship can be summarized as follows:

1) If demand is price elastic (a proportionate change in price

causes a more than proportionate change in quantity demanded)

then an increase in price will reduce total revenue while a fall in

price will increase total revenue.

2) If demand is price inelastic (a proportionate change in price

results in a less than proportionate change in quantity

demanded) then an increase in price will increase total revenue

while a decrease in price will reduce total revenue.


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3) If demand is unit price elastic (a proportional change in price

causes a proportionate change in quantity demanded) then

changes in price will not produce any change in total revenue.

To illustrate this consider the diagrams below:

To illustrate the relationship between PED and Revenue:

Check book

Price elastic demand Price- inelastic demand.

Curves D1 and D2 represent price elastic and inelastic demand curves

respectively.

An increase in price from p1 to p2 in both cases will cause a fall

in quantity demanded from q1 to q2.


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The revenue lost by the producer as a result of the fall in

quantity demanded is represented by area Y while the gain in

revenue as a result of the increase in price is represented by

areas X. The case of price elastic demand, X < Y thus a fall in

total revenue while in the case of price inelastic demand, X > Y

thus an increase in total revenue.

A fall in price will have the opposite effect for both cases.

2. Income Elasticity of Demand (Ey)

This refers to the measure of the degree of responsiveness of quantity

demanded of a commodity to changes in consumers income or the

degree to which an increase in income will cause an increase in

demand is called income elasticity of demand, which can be

expressed in the following equation:

It is calculated using the following general formula.


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Income elasticity of demand = Ey

= a proportionate change in

quantity demanded

a proportionate change in income

If Ey > 1, demand is said to be income elastic e.g. 100%

change in income resulting in 120% change in quantity

demanded.

If Ey < 1, demand is said to be income inelastic e.g. 50%change in income resulting in a 20% change in quantity

demanded.


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If Ey = 1 demand is said to be unit income elastic e.g. a 10%

change in income resulting in a 10% change in quantity

demanded.

In general the income elasticity of luxuries is greater than 1

while that of necessities is less than 1. The value of income

elasticity of demand for normal goods is positive because of

the direct relationship between income and quantity

demanded. If Ey has a negative value, the commodity in

question is an inferior good.

If EDy is greater than one, demand for the item is considered to

have a high income elasticity. If however EDy is less than one,

demand is considered to be income inelastic. Luxury items

usually have higher income elasticity because when people have

a higher income, they don't have to forfeit as much to buy these

luxury items. Let's look at an example of a luxury good: air travel.

Bob has just received a $10,000 increase in his salary, giving hima total of $80,000 per annum. With this higher purchasing power,

he decides that he can now afford air travel twice a year instead


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of his previous once a year. With the following equation we can

calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is seven

- highly elastic.

With some goods and services, we may actually notice

a decrease in demand as income increases. These are

considered goods and services of inferior quality that

will be dropped by a consumer who receives a salary

increase. An example may be the increase in the

demand of DVDs as opposed to video cassettes, which

are generally considered to be of lower quality.

Products for which the demand decreases as income

increases have an income elasticity of less than zero.

Products that witness no change in demand despite achange in income usually have an income elasticity of

zero - these goods and services are considered

necessities.


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Determinants of Income Elasticity of Demand

a. Nature of the commodity: Is it an

inferior

b. Level of income: e.g. a TV set is a luxury in an

underdeveloped country while in a developed country

with high per capital income it is a necessity.

c. Time Period: Consumption patterns adjust with a time

lag to changes in income. Demand will therefore tend

to be income elastic in the long run than in the short

run.

3. Cross Elasticity of Demand (Ex)

This refers to the degree of responsiveness of quantity

demanded of a given product to changes in the price of a

closely related commodity. It is measured using the

following general formula


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Ex = Proportionate change in quantity demanded of A

Proportionate change in price of B

B can either be a substitute or a compliment.

Cross elasticity of demand measures the degree of

substitutability and complimentarity between different

products. Substitutes have a positive cross elasticity of

demand and the higher the positive value of Ex the higher the

degree of substitutability. Compliments have a negative

cross elasticity of demand and the higher the negative value

of the co-efficient of Ex the higher the degree of

complimentarity between the two commodities.

The main determinant of cross elasticity of demand is the

nature of the two commodities relative to their uses e.g. if two commodities can satisfy equally well the same need, the

cross elasticity between them will be high and vice versa.


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Importance/Applications of Elasticity of Demand

1. Price Elasticity of Demand

i) Sales Revenue: the concept of price elasticity of

demand is important for a businessman in

predicting the effect of changes in price on his

sales revenue.

ii) Consumption Patterns: if the government wants to

discourage the consumption of a particular

commodity through taxation, this policy will only

be effective if the price elasticity of demand of the

commodity is high.

iii) Tax Shifting: refers to the transfer of the money

burden of taxation by a producer on whom the tax

is imposed to the consumer in the form of

increased product prices. The extent to which this

burden can be transferred depends on the price

elasticity of the commodity in question. To

illustrate this consider the diagrams below.

To illustrate tax shifting: (Chek bk)


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Price elastic demand Price inelastic

demand

DD and D1D1 represent elastic and inelastic

demand curves respectively.

The equilibrium price is OP1 and the quantity

OQ1. SS is the initial supply curve.

Suppose there is an imposition of a unit tax on the

producer of this commodity the effect would be afall in supply reflected by the shifting of the

supply curve to the left from SS to S1S1. A new

equilibrium price would be established at Opt.


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The vertical distance between the two supply

curves at any point represents the unit tax. ThusAC in the diagrams above represents the unit tax.

Out of this the consumer pays AB in the form of

increased product prices and the producer BC

which represents un-shifted tax burden.

In the case of elastic demand, AB is less than BC

while in the case of inelastic demand AB is

greater than BC. Thus it is when the price

elasticity of demand is slow the firm can transfer

most of the burden of taxation to the consumer.

iv) Devaluation: price elasticity of demand is relevant

if a country is considering devaluation as a means

of rectifying balance of payment problems.

Devaluation generally refers to the cheapening of

the value of a countrys currency in terms of other

foreign currencies. This will reduce export and

increase import prices. Whether or not this will


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improve the balance of payment situation depends

on the relevant price elasticities of demand i.e. the

higher the price elasticity of demand for imports

and exports the greater the improvement on the

balance of payment.

v) Fluctuations in agricultural prices: the more

inelastic the demand for agricultural products are,

the more widely prices will fluctuate with changes

in output from period to period. To illustrate this

consider the diagram below.

To illustrate relationship between PED and price

instability in agriculture.


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DD and D1D1 represent inelastic and elastic demand curves

respectively.

SS is the initial supply curve and OPe and Oqe is

equilibrium price and quantity respectively.

Suppose there is a fall in supply of this

agricultural commodity because of a poor harvest,

this would be represented by the shifting of thesupply curve to the left as shown in the diagram

above. The equilibrium price established would

depend on the price elasticity of demand i.e. under

conditions of inelastic demand as represented by

DD prices will fluctuate from Pe to P2 while

under conditions of the elastic demand as

represented by D1D1 prices will fluctuate less

sharply from Pe to P1.

N.B.: The demand for agricultural commodities

tend to be price inelastic because they constitute a

small proportion of the manufacturers demand

and also most of the agricultural commodities

consist of foodstuffs.


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2. Income Elasticity of Demand

Resource Allocation: the concept of income elasticity

of demand has wide implications on resource allocation

e.g. as a country experiences economic growth the

proportion of income spent on luxury will be increasing

while that spent on necessities will be falling. This

information would be useful if the government is

making policy decisions and for private firms in making

decisions on production and employment.

3. Cross Elasticity of Demand

i) Protection Policy: the concept of cross elasticity

of demand is useful to the government in

predicting the effects of its protection policy e.g.

if the government imposes a tariff on an imported

commodity with the intention of protecting a local

industry, then the local and imported product must

be close substitutes for the government to achieve

its objective. If the imported commodity is of a

relatively higher quality then the imposition of the


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tariff will not achieve its end as people will still

buy the imported product.

ii) Competition and Prices: if a firm is in competitive

industry, there would be a high cross elasticity

between its products and those of other firms. For

such a firm it may not be in its interest to increase

price rather it will try to attract consumers from

other firms by lowering its price.

ADVERTISEMENT OR PROMOTONAL ELASTICITY OF

SALES

The expenditure on advertisement and on other sales-promotion

activities do help in promoting sales, but not in the same degree at all

levels of the total sales. The concept of advertisement elasticity is useful

in determining the optimum level of advertisement expenditure.

Point advertisement elasticity (E A) of sales may be defined as

Q A

AQ

A AQQ

AQ

E A

.

/

/

%

%


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The value of Q/A is computed by taking the derivative of Q x with

respect to A, which equals a 6. Therefore, the formula for the point

advertisement elasticity of demand or sales can be rewritten as

X A Q

Aa E 6


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Interpretation of advertisement-elasticity: The advertisement

elasticity of sales varies between E A = 0 and E A = .

Elasticities Interpretation

EA = 0 Sales do not respond to the advertisement

expenditure.

0 < E A < 1 Increase in total sales is less than proportionate to the

increase in advertisement expenditure.

EA > 1 Sales increase at higher rate than the rate of increase

of advertisement expenditure.

Determinants of Advertisement Elasticity

The following factors determine the advertisement elasticity.

a. Level of the total sales . In the initial stages of sales of a product,

particularly of one which is newly introduced in the market, the

advertisement elasticity is greater than unity. As sales increase, the

elasticity decreases.


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b. Advertisement by rival firm . In a highly competitive market, the

effectiveness of advertisement is determined also by the relative

effectiveness of advertisement by the competing firms.

c. Cumulative effect of past advertisement . In case expenditure

incurred on advertisement in the initial stages is not adequate

enough to be effective, elasticity may be very low. But over time,

additional doses of advertisement expenditure may have

cumulative effect on the promotion of sales and advertisingelasticity may increase considerably.

d. Advertising elasticity is also affected by other factors affecting

demand for product, e.g., change i n products price, consumers

income, growth of substitute and their prices.

Elasticity of Supply

This is defined as a measure of the extent to which quantity

supplied of a product responds to changes in the influencingfactors.

Price Elasticity of Supply (Es)


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This refers to a measure of the degree of responsiveness of

quantity supplied of a product to changes in the price of the

commodity. It is calculated using the following general formula:

Price Elasticity of Supply = Es = Proportionate Change in Quantity

Supplied

Proportionate Change in Price

For point elasticity of supply

Qs * P

P Q

For arc elasticity of supply

Qs * P1+P2

P Q1+Q2


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N.B.: Es will have a positive value because of the direct relationship

between quantity supplied and price.

If Es > 1 supply is said to be price elastic.

If Es < 1 supply is said to be price inelastic.

If Es = 1 supply is said to be unit price elastic.

Relationship between Price Elasticity of Supply and the Supply

Curve

To illustrate this relationship consider the diagram below:


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Thus as the slope of the curve increases, price elasticity of supply

is reducing and vice versa. Therefore, there is an inverse

relationship between price elasticity of supply and the slope of the

supply curve.

N.B.: Steeply sloping supply curves will be associated with

inelastic supply while gently sloping supply curves will beassociated with elastic supply.

Types of Price Elasticities of Supply

1. Perfectly inelastic supply: supply is said to be perfectly

inelastic if quantity supplied is constant at all prices thus Es

in this case = 0 and the curve would be a vertical straight

line. This is illustrated below.

To illustrate perfectly inelastic supply


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This is the case of a very short run situation where increases

in price do not cause an increase in quantity supplied e.g.

goods brought to the market in the morning cannot be

immediately increased as prices increase.

2. Inelastic supply: supply is said to be price inelastic if a

proportionate change in price causes a less than proportionate

change in quantity supplied. In this case the value of Es < 1

and the supply curve touches the X axis this is illustrated in

the diagram below.

To illustrate price inelastic supply


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This is the case of a commodity with limited stock or one,

which takes a long time to produce. Thus when price isincreased quantity supplied cannot be increased drastically.

Also it is the case of a highly perishable product, which if

price falls quantity supplied cannot be reduced substantially

through storage e.g. milk.

3. Unit price elastic supply: supply is said to be unit price

elastic if changes in price bring about changes in quantity

supplied in equal proportions. The value of Es in this case =

1 and the supply curve is a straight line passing through the

origin. This is illustrated below.

To illustrate unit price elastic supply


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This is the case of a commodity with adequate stock or one,

which can be produced, in a fairly short period of time. Thuswhen price increases supply can easily be expanded or it is

the case of a product, which is relatively non-perishable and

cannot be stored. Thus when price falls supply can easily be

contracted.

4. Price elastic supply: supply is said to be price elastic if a

change brings about a change in quantity supplied in a

greater proportion. The value of Es in this case > 1 and the

supply curve touches the Y-axis. This is illustrated below.

To illustrate price elastic supply


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This is the case of a commodity with plenty of stock or one

which can be produced in a very short period of time. Thus

if price increases quantity supplied can be expanded very

easily. It is also the case of a manufactured commodity

which can be easily stored instead of being sold at a loss or ata reduced profit margin.

5. Perfectly price elastic supply: supply is said to be perfectly or

infinitely price elastic if price is fixed at all levels of supply.

The value of Es = and the supply curve is a straight horizontal

line.

6. This is illustrated below.

To illustrate perfectly price elastic supply


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This is the case of price controls.

Factors Determining Price Elasticity of Supply

1. Level of employment : with a situation of full

or near full employment of resources, the

supply of most commodities will tend to be

price inelastic. This is because with an

increase in demand which results to an

increase in prices, production cannot be

expanded. To increase production at full

employment will call for an improvement intechnology or discovery of new economic

resources. This too may not be possible in

the short run.


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2. Mobility of factors of production: the

higher the degree of factor mobility the

more responsive quantity supplied of a

commodity will be to changes in price. If

the factors of production are relatively

mobile supply will tend to be price elastic.

3. Production time: if it takes a long time to

produce a commodity, its supply will tend to

be price inelastic e.g. production of wine.Supply will however be price elastic if the

production time is relatively shorter.

4. Level of stock : if the level of stock of a

particular product is high supply would be

price elastic. This is because with increases

in price more supplies would be retrieved

from the store.

5. Nature of the commodity: price elasticity of

supply will depend on the nature of

commodities i.e. the supply of perishable

products will not respond to a fall in price asthey cannot be stored. On the other hand the

supply of manufactured products will

decrease with a fall in price of the items.


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6. Time interval: supply will tend to be price

elastic in the long run than in the short run.

7. Risk taking: the more willing entrepreneurs

are to take risks the more supply will be

responsive to changes in price

Applications of Price Elasticity of Supply

1. If supply of a commodity is price elastic, an increase in

demand will benefit both the producer and the consumer.

This is because the producer will be in a position to supply

relatively more of his commodity and the consumer to pay a

relatively lower price. To illustrate this, consider the diagram

below.

To illustrate effect of a change in demand under conditions of

elastic and inelastic supply


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The diagram above combines two conditions of supply i.e.

when supply is price elastic as represented by S1 and when it

is price inelastic as represented by S. The original demand

curve is DD which intersects with the supply curve to

establish an equilibrium price of OPe and quantity OQe. If demand increases the demand curve will shift to the right

from DD to D1D1. Two possible new equilibrium positions

would be established depending on the elasticity of supply.

If supply is relatively price inelastic as represented by SS an

increase in demand will establish a new equilibrium price of

OP2 and quantity OQ2. If however, supply is relatively price


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elastic the new equilibrium price will be relatively lower at

OP1 and quantity relatively higher at OQ1.

2. If supply is price inelastic businessmen risk losing revenue

when there is a fall in price. This is because they would be

forced to sell their product at a loss or at a reduce profit

margin. If however, supply is price elastic businessmen can

store their products when prices fall thus contracting supply.

3. The possibility of shifting part or whole of the money burden

of tax by a producer to a consumer will also be determined

by the price elasticity of supply.

The more inelastic the supply of a commodity is the more

difficult it is for the producer to shift the money burden of tax

to the consumer.

Reasons why agricultural prices fluctuate

One of the main problems facing the agricultural industries is the

instability of prices of agricultural products which fluctuate more

widely than the prices of industrial products. The reasons for these

fluctuations derive from the elasticity of demand and supply of


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agricultural products and their supply conditions. Specifically

these reasons include:

i) The supply of agricultural products is more directly affected by natural forces such as weather, diseases and pests than the

supply of industrial products. In most cases these natural

forces tend to be unpredictable and beyond the control of the

farmers. Thus in agriculture there is always a divergence

between planned and actual output while in industry output is

relatively predictable. The effect of divergence is a shift of

the short run supply curve whose position will depend on

whether the harvest is good or bad.

ii) Fluctuation in prices resulting from natural forces are

intensified by the inelasticity of supply. The short run supply

curve tends to be price inelastic because of the followingreasons:

a) Once a given amount of crop has been planted, it is

difficult to increase or decrease the resulting output.

b) It is relatively difficult to store agricultural products as

most of them tend to be perishables. To illustrate how

inelasticity of supply worsens price fluctuations

resulting to natural forces consider the diagram below:


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DD is the initial demand curve and Ls is the long run

supply curve indicating the amount that producers

would plan to supply at each and every price. Thus

OPo and OQo would be the equilibrium price and

quantity respectively if actual production was to equal planned production.


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If however, as a result of natural forces, the production

of agricultural products was to be below planned

production say, at OQ1, and were fixed at this amount

the short run supply curve would become S1

establishing an equilibrium price of OP1.

On the other hand, if actual production was to exceed

planned production say, at OQ2 and was fixed at this

amount the short run supply curve would become S2

establishing an equilibrium price of OP2.

Thus fluctuation in the amount produced and supplied

can produce wide fluctuations in prices of agriculturalcommodities. If the short run supply curve had not

been perfectly price inelastic say, S3 instead of S1, the

rise in price in the first instance would only have been

to OP3 instead of OP1.

If the short run supply curve had been more elastic as

represented by S4 the rise in price would have been still

less to OP4.


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Thus the more inelastic the short run supply curve, the

more fluctuations in price produced in a change insupply.

iii) The effect of fluctuation in the amounts supplied is

aggravated in the case of agricultural products by the

inelasticity of supply. . The demand for agricultural products tend to be price inelastic because of the following 2

reasons:

a) Agricultural products consists mainly of food stuffs

whose demand tends to be inelastic especially in the

case of staple foods.

b) Most agricultural commodities are only inputs used in

the production of other products and form a very small

proportion of the total cost of that product. To illustrate

how inelasticity of demand aggravates price instability

consider the diagram below:

To illustrate how inelasticity of demand increases price

instability


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The initial equilibrium is at price OPo and at quantity

OQo. Ls is the planned output. Suppose there is a

divergence between planned output and actual output,

the short run supply curve will shift to the left if the

actual supply was less than the planned supply i.e. S1.

The new equilibrium price established will depend onthe elasticity of demand. If demand is relatively price

elastic as represented by D1, the rise in price would be

a sharp one to OP1. On the other hand, demand is


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relatively price elastic as represented by D2, the rise in

price would be a more moderate one to OP2. Thus, the

more inelastic the demand for a product is the more

sharply prices will fluctuate as a result of a change in

supply.

iv) Nature of commodity: price fluctuation of agricultural

commodities will also depend on the degree to which it is

possible to store the product i.e. a sharp increase in price

could be prevented during a shortage in output by sale from

stock. A fall in price during a glut could be prevented by

adding the excess output to the stock.

The extent to which this is possible depends on how easily a

product can be stored. Most agricultural products are often

perishables e.g. fruits, flowers, etc. Industrial products on the

other hand tend to be less perishable thus easy to store.

This difference is reflected by the wide seasonal variations in

prices exhibited by many agricultural products.

v) Cobweb theorem:


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Equilibrium prices are also difficult to attain because of the

lagged response by farmers to price . To illustrate this,

suppose that supply which is a function of price is written as

follows:

St = f (Pt) where t is the time period.

In agriculture however, it is the price of the previous period

that determines the supply in the current period i.e. farmers

will look at this years price in determining how much of the

crop to plant for the next year i.e.

St = f (Pt 1)

The effect of this lagged response of the farmers on market

equilibrium is explained by the cobweb theorem whose

diagram is illustrated below.

To illustrate the Cobweb Theorem


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Suppose both the diagrams above show the demand and

supply curves for corn.

In year 1 for some reason, the price is at OP1. At this price

farmers would wish to supply a quantity of OQ1 and are thus

encouraged to do so for year 2. In year 2, the output is OQ1

and is fixed at that quantity in the short run. However, an

output of OQ1 can only be sold at a price of OP2 thus price

falls to this level.

This low price discourages farmers from planting corn and so

they only produce an amount of OQ2 in the following year.

However, this is sold at a higher price of OP3. The price of

OP3 encourages farmers to produce more and so on.


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From the diagram above, tracing a line through the relevant

points on the demand and supply curve, a cobweb is obtainedhence the name of the theorem.

There are a number of means available to the government to

stabilize prices and also incomes to the farmers. They include the

following:

i) Operation of a buffer stock: in this case the government

buys part of the supply when output is excessive, stores

the surplus and resells it to the consumer in times of

shortage or reduced supply. This will have the effect of

stabilizing prices of agricultural commodities.

ii) Operation of a fund: instead of actually dealing with the

commodity, the government could choose only stabilize

only the farmers income. This is done through a fund,

which the government could make direct payments to

growers by purchasing products at a given price and

selling it to consumers at market price. The price is set

in such a way as to ensure a stable income to farmers


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despite fluctuations in output. The operation of the fund

is done through a marketing board.

iii) Price control: through the use of a minimum price, the

government can ensure adequate income to farmers and

also stabilize prices of agricultural products.

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